Repo market capacity constrains Fed balance sheet size
A new Federal Reserve paper argues that repo market capacity, driven by money market fund liquidity, is the primary constraint on the Fed's balance sheet size. This finding challenges the traditional view that bank reserve demand is the binding factor.
Beyond bank reserves
The paper introduces repo market capacity as a novel constraint on the Fed's balance sheet, distinct from bank reserve demand.
It calibrates a structural model to the recent monetary tightening cycle, demonstrating that the supply of money from non-banks, particularly money market funds (MMFs), dictates this capacity.
This mechanism, rather than bank reserve demand, is shown to be the binding constraint, especially in contrast to the events of September 2019 where reserve demand was highlighted.
The authors contend that ignoring non-bank money supply could lead to a loss of control over the effective federal funds rate, undermining central bank credibility and increasing funding market volatility.
The model provides a unified framework to quantify the implications for repo market conditions and the minimum balance sheet consistent with ample reserves.
Policy rates and balance sheet size
The research reveals a complementarity between interest rate and balance sheet policies: higher policy rates expand repo capacity, enabling the central bank to operate with a smaller balance sheet.
This implies that quantitative tightening (QT) can proceed further when the policy rate is elevated.
During QT, the Fed reduces its balance sheet by not replacing maturing Treasury securities, which increases demand for repo borrowing while reducing liquid funding supply.
MMFs play a crucial role, reallocating funds from the Overnight Reverse Repurchase (ON RRP) facility to the repo market as QT continues.
Once ON RRP take-up reaches zero, repo rates increase, attracting household deposits to MMFs.
A new paradigm for QT
This paper fundamentally redefines the understanding of central bank balance sheet constraints.
Its findings offer critical insights for the future conduct of quantitative tightening, suggesting a more nuanced approach is needed.
Policymakers must now consider repo market dynamics and non-bank liquidity as central to effective monetary policy implementation.